JulieRannazzisi

NEW YORK (CBS.MW) -- Brazil, which most pundits dubbed the wild card of financial markets in 1999, is back in the limelight: Market strategists say the future of Latin America's largest economy appears more and more uncertain, with perils at every corner.

Dashing investors' hopes that Brazil was on the job and getting its fiscal house in order was news that Itamar Franco, the governor of Minas Gerais, Brazil's second-largest state, had threatened to suspend all payments on $15 billion in debt owed to the government for 90 days.

The negative news, which emerged late Wednesday, came just after the international community was comforted by the successful passage in Brazil's Senate of a key fiscal austerity measure -- the financial transaction tax -- which could bring in revenues of $8.3 billion in 1999. Still, observers say, the peskier task will be getting the lower house to approve the measure, which may be voted on in February.

Josh Feinman, global economist at Bankers Trust, said a positive development coupled with a negative one is typical of Brazil's pattern. The country takes "one step forward and one step back," he said.

Thursday afternoon, Brazil's Finance Ministry attempted to shake market fears by announcing that the government would honor all of its obligations, internal and external.

But the soothing comments were to no avail, as the capital markets showed their lack of confidence Thursday by taking down Latin American debt markets and leaving Brazil's Bovespa with a crushing 5.14 percent loss. And capital continued to pour out of Brazil at a dizzying pace.

Brazil's current debacle appears to be more one of political implications than fiscal ones. Still, experts say, if Brazil doesn't present a unified front in its quest for fiscal health, how can it ever hope to pass all the measures necessary to ensure it receives the $41.5 billion earmarked by the International Monetary Fund?

The unstable political environment in Brazil suggests fiscal measures can't be passed without a glitch, according to Bill Sullivan, senior vice president and chief money market economist at Morgan Stanley Dean Witter.

The market knows that Franco is a radical and a vigorous opponent of President Fernando Cardoso. But while it's clear that the moratorium is being used by Franco for political reasons, it comes at a most unfortunate time.

Brazil's government still has to pass several measures contained in its fiscal austerity package, and political opposition at this stage is grave, according to Garcia. The risk is that five other opposition governments and two in particular -- the states of Rio De Janeiro and Rio Grande -- will be tempted to follow in the steps of Minas Gerais, Garcia said.

The six opposition governors are scheduled to met on Jan. 18 to discuss ways to renegotiate their government debt, Garcia noted. But if the governors are able to obtain any concessions from the government, other states would ask for the same advantages and the implementation of the country's fiscal program would be dangerously at stake.

Garcia said he best move for Brazil is to effectively isolate Franco and not concede to his requests. He doesn't expect other opposition governors -- who are more conservative compared to Franco -- to follow in the moratorium steps.

Sullivan sees the current debacle as a reminder that there are still pronounced wrinkles and risks in emerging markets.

Default threats loom

The harsh reality for Brazil is that a painful recession awaits the country with no possible way to avoid this mammoth contraction of economic growth. The best case scenario would see Brazil successfully implement its austerity package and receive the IMF's blessing and funding. Brazil may be back on track fiscally at that point, but it will still have to face a couple of years of disastrous negative growth due to the slashes in spending and tax hikes, Feinman explains.

That means Brazil may have to devalue its currency, the real, to alleviate the pressure on its economy and reserves. "There's a very strong case that (Brazil's) currency will have to be devalued," Feinman remarked. But how can that be done without killing investor confidence and ungluing the rest of Latin America?

The most compelling challenge is to devalue without wreaking havoc to the global financial system, Feinman said. "Brazil still has a very tough road to hoe," Feinman concluded.

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